The effect of R&D on future returns and earnings forecasts

Transcription

1 Rev Account Stud DOI /s y The effect of R&D on future returns and earnings forecasts Dain C. Donelson Robert J. Resutek Ó Springer Science+Business Media, LLC 2012 Abstract Prior studies attribute the future excess returns of research and development activity (R&D) firms to either compensation for increased risk or to mispricing. We suggest a third explanation and show that neither the level of R&D investment nor the change in R&D investment explains future returns. Rather, the positive future returns that prior studies attribute to R&D investment are actually due to the component of the R&D firm s realized return that is unrelated to R&D investment but present in R&D firms. Our results suggest that the excess returns of R&D firms are part of the larger value/growth anomaly. In addition, we show that while future earnings are positively associated with current R&D, errors in earnings expectations by investors and analysts are not related to R&D investment. Keywords R&D Value/growth Investment Mispricing Earnings forecasts Analysts JEL Classification G14 M41 1 Introduction This study examines the relation between research and development activity (R&D), earnings forecasts, and future stock returns. Prior research finds positive We thank Ross Jennings, Bill Kinney, Jonathan Lewellen, Theodore Sougiannis, Eric Yeung, and workshop participants at the University of Texas Summer Brownbag Series and the 2009 American Accounting Association Annual Meeting for comments and suggestions. D. C. Donelson McCombs School of Business, University of Texas at Austin, Austin, TX, USA R. J. Resutek (&) Tuck School of Business, Dartmouth College, 100 Tuck Hall, Hanover, NH 03755, USA

2 D. C. Donelson, R. J. Resutek associations between future stock returns and current R&D intensity (for example, Chan et al. 2001; Chambers et al. 2002) and current R&D growth (for example, Penman and Zhang 2002; Eberhart et al. 2004). Some studies suggest that the future returns associated with R&D firms are compensation for risk, while other studies suggest that investors misprice the earnings of R&D firms leading to predictable future return patterns (Lev et al. 2005). Our study suggests a third explanation for the future returns of R&D firms. Specifically, our results suggest there is no direct relation between a firm s R&D investment and future returns. Rather, the significant future returns of R&D firms noted in prior studies are due to differences in investor expectations about future earnings and asset growth that are not directly related to R&D. These differences in investor expectations are consistent with well-known characteristics associated with the value/growth anomaly. However, predictable differences in investor and analyst expectations are not related to a firm s R&D activity. Our analysis proceeds in three stages. First, we leverage the empirical design of Daniel and Titman (2006) and use realized log returns as a proxy for the total valuerelevant information investors incorporate into price. We decompose realized log returns into two orthogonal components: an R&D return component ( R&D returns ) and a non-r&d component ( non-r&d returns ). The advantage of this research design is that the R&D returns serve as an empirical proxy for the R&D information investors incorporate into stock price. More importantly, we have an orthogonal empirical proxy for all the value-relevant information other than R&D that investors incorporate into stock price. Our results suggest that both the level of R&D and changes in R&D are unrelated to future returns. Just as important, we show that non-r&d information, captured by our non-r&d returns variable, is strongly negatively associated with future returns. Second, we investigate the effect that R&D investment has on the interpretation of current earnings by investors and the prediction of future earnings by analysts. We do this to further examine the earnings fixation explanation provided in prior studies. Our results suggest that investors interpret the current earnings of R&D firms similar to the earnings of non-r&d firms. Our evidence also suggests that analyst forecast errors are unrelated to R&D activity. Consistent with our results regarding future returns, forecast errors are attributable to non-r&d information, not R&D investment. Finally, we examine the type of information captured in non-accounting variables such as non-r&d returns. Prior studies such as Daniel and Titman (2006) and Resutek (2010) refer to non-accounting returns as intangible returns but do not directly examine what value-relevant information they represent. We examine the composition of these non-accounting returns and show that they are positively associated with future asset growth, future earnings, and to a lesser extent, negatively associated with future earnings growth. These relations are slightly stronger in R&D firms than non-r&d firms. These results provide some economic intuition as to why R&D firms tend to realize higher future returns than non-r&d firms with similar characteristics and help map the R&D return anomaly into the broader value/growth anomaly.

3 The effect of R&D on future returns and earnings forecasts Our study makes several contributions to the literature. First, we find that a firm s R&D investment is unrelated to future returns and analyst forecast errors. A relatively extensive literature examines the anomalous positive relation between R&D investment and future returns. While generally accepted accounting principles (GAAP) require the immediate expensing of R&D due to the uncertainty of future benefits and the difficulty in matching the expense with sales (SFAS No. 2 para. 39 and 49, Lev and Sougiannis 1996; Kothari et al. 2002), some studies suggest that immediate expensing of R&D misleads investors and causes mispricing (for example, Lev et al. 2005) and that managers should be given more discretion and opportunity to capitalize R&D investment. 1 Our findings suggest that while R&D is value-relevant to investors and analysts, the accounting treatment of R&D does not lead to systematic forecast errors. Second, our study builds on Daniel and Titman (2006) and Resutek (2010), which show that the information investors incorporate into stock price that is not captured by accounting information (called intangible returns in each study) affects inferences between accounting metrics and future returns. However, neither study examines the relation between future earnings expectations and realized intangible returns. This relation is important to understand because forecast errors are often used to explain future returns. Our results suggest that investors and analysts make unbiased earnings projections based on current earnings and that the presence of R&D investment does not lead to predictable forecast biases. These results complement Daniel and Titman (2006) and Resutek (2010) by linking the properties of intangible returns to properties of earnings forecasts and earnings forecast errors. Finally, our results help to tie the future returns of R&D firms into the larger value/growth literature. Lev and Sougiannis (1999), Chan et al. (2001), and Daniel and Titman (2006) each suggest that the value/growth anomaly is stronger in R&D firms, potentially indicating that R&D contributes to investor mispricing or shifts in firm risk. Our results suggest a slightly different interpretation. We find that R&D does not amplify the future returns of value and growth firms per se. Rather, the stronger future returns of R&D firms are associated with investors incorporating more value-relevant information into price that is not captured by R&D or summary accounting measures of growth. Section 2 discusses prior literature and develops our research question. Section 3 describes our research design. Sections 4 and 5 discuss our primary empirical results and robustness tests. Section 6 provides concluding remarks. 2 Prior literature Prior studies find that the level of R&D investment (generally referred to as R&D intensity in the literature) and growth in R&D investment are both positively associated with future returns (for example, Chan et al. 2001; Eberhart et al. 2004). 1 In addition, the Securities and Exchange Commission has issued a roadmap to align GAAP with International Financial Reporting Standards (IFRS) in the near future. Conversion to IFRS-style standards would likely lead to more recognition of assets related to R&D activity because IFRS currently allows firms to capitalize a broader range of development costs.

4 D. C. Donelson, R. J. Resutek Like many return anomalies involving accounting information, both risk and mispricing explanations have been offered. With respect to a risk-based explanation, Chambers et al. (2002) find that, while firms exhibit consistently higher returns in event time, there is high variation of returns in calendar time. These results are consistent with risk explaining the future return pattern of R&D firms. Similarly, Lev and Sougiannis (1999) show that the book-to-market return reversal pattern is significantly stronger in R&D firms, consistent with risk characteristics associated with R&D activity affecting the risk characteristics of value/growth firms. 2 The mispricing explanation for the relation between R&D activity and future returns relies on the hypothesis that investors fail to appreciate the positive implications of current R&D on future earnings. Specifically, investors underestimate future earnings because they do not understand that R&D costs incurred in the current period function more like an investment which produces future revenue rather than an expense (which is matched against current revenue). Then, investors reassess their earnings expectations in future periods when the benefits are unexpectedly realized, leading to a positive relation between future returns and current R&D (see Lev and Sougiannis 1996; Eberhart et al. 2004; Lev et al. 2005; Ali et al. 2009). 3 Interestingly, there is little work linking the future return patterns associated with R&D investment to those associated with tangible, capitalized investment. This lack of research is curious because, while the accounting literature notes a positive relation between investment in R&D and future returns, a significantly larger number of studies in accounting and finance find a negative relation between future returns and tangible asset investment (for example, Sloan 1996; Titman et al. 2004; Cooper et al. 2008). This relation between tangible investments and future returns poses a puzzling question why do two types of investment, both of which are linked to firm growth, produce opposite future return patterns? Occam s razor suggests that there should be a common explanation for the future return patterns of both types of investment, whether it is a common firm characteristic, mispricing pattern, or risk factor shared across firms. However, many firm characteristics are associated with firm growth, investment, and future returns. Compounding the dilemma is the joint-hypothesis problem, which suggests that empirical tests of whether investors rationally incorporate information into stock price are joint tests of market efficiency and of the model for expected returns (Fama 1970). Recent work in finance and accounting suggests an empirical design that may be useful in distilling the variation in future returns attributable to R&D from the 2 In related work, Kothari et al. (2002) find that future earnings volatility is higher for R&D investments relative to capital expenditures, consistent with R&D increasing operating risk. Shi (2005) and Eberhart et al. (2008) examine the relation between R&D and risk to bondholders. Both find that R&D affects the inherent risk to bondholders, although they reach opposing conclusions as to whether R&D increases or decreases bondholder risk. 3 In a related study, Penman and Zhang (2002) suggest that certain accounting mechanisms related to conservatism, including the immediate expensing of R&D, affect investors assessments of future earnings in predictable manners.

5 The effect of R&D on future returns and earnings forecasts variation explained by other value-relevant information. Specifically, Daniel and Titman (2006) assume that the realized return variation over a given period of time (for example, 1, 5 years, etc.) is a good proxy for the total value-relevant information investors incorporate into price over that period. Building on this assumption, they decompose realized returns into two primary components. The first component, termed the tangible return component, constitutes the component of total return over a given period of time that is explained by summary accounting return metrics (for example, change in book value, sales growth, etc.). The second component, termed the intangible return component, captures the component of total return unexplained by the summary accounting return metric. Daniel and Titman (2006) use this decomposition to show that the future return pattern associated with the value/growth anomaly is not due to investors mispricing longhorizon measures of accounting growth, as suggested by Lakonishok et al. (1994). Rather, Daniel and Titman (2006) suggest that the future return pattern that characterizes the value/growth anomaly is due to a negative relation between intangible return components and future returns. Resutek (2010) modifies the Daniel and Titman (2006) empirical design and provides evidence that the accrual anomaly (as short-term return reversal) can be viewed as a function of the value/growth anomaly and that prior period intangible returns explain the negative relation between current period accruals and future returns. R&D firms have several characteristics suggesting that intangible returns could explain the return pattern associated with R&D investment. First, the payoff to R&D is uncertain both in timing and in substance. Building on the theoretical behavioral asset pricing literature, Daniel and Titman (2006) hypothesize, but do not test, that intangible returns could be positively related to a firm s R&D activity. Further, high R&D intensity firms tend to have recently experienced poor stock performance and low stock prices, similar to traditional value firms (for example, Chan et al. 2001). 4 Accordingly, it is possible that the positive association between R&D intensity and future returns is due to a negative association between intangible returns and future returns. Ultimately, a carefully designed empirical test is required to distill the future return variation explained by R&D investment from that explained by other firm characteristics shared by R&D firms. In other words, because R&D activity is correlated with other accounting variables and firm characteristics that are also associated with future returns (particularly other forms of firm investment and growth), it is important to employ a research design that can effectively control for these joint correlations. As noted above and discussed in more detail below, by orthogonalizing the value-relevant information that investors incorporate into price that is related to R&D from that unrelated to R&D, we can make stronger inferences on the relation between future returns and R&D. These inferences are possible because we do not need to directly define each and every variable that is jointly correlated with future returns and R&D. Rather, we classify value-relevant 4 Some studies attribute the poor stock performance to investors fixating on the negative impact of R&D on current earnings. However, as Daniel and Titman (2006) note, stock price can move for reasons unrelated to a firm s current earnings. For example, the approval or rejection of a pharmaceutical firm s drug patent could have a huge effect on the firm s stock price but would not affect its current earnings.

6 D. C. Donelson, R. J. Resutek information as either related to R&D or unrelated to R&D. Further, because we use realized returns as our proxy for the total value-relevant information investors incorporate into price over a period, we can also control for information that is hard to empirically capture (for example, shifts in expectations of future earnings, asset growth, earnings growth, etc.) but known to be associated with future returns. 3 Research design As noted above, we leverage the empirical design of Daniel and Titman (2006) and decompose realized returns, our proxy for total value-relevant information used by investors over a given period, into two components: an R&D component and a non- R&D component. The R&D component represents the value-relevant weight investors place on the R&D investments of a firm. In other words, if realized return variation maps strongly into R&D investment variation, then investors are placing a strong weight on the importance of R&D. Accordingly, the non-r&d component of realized returns represents the value-relevant weight investors place on all other information. The following two logarithmic decompositions of R&D intensity (R&D scaled by current market value of equity, RDME t ) demonstrate the intuition behind our empirical design: log RD t ¼ rdme t ¼ log RD t 1 þ D log RD t 1;t ð1þ ME t ME t 1 ME t 1;t ¼ log RD t 1 ME t 1 RD t þ log RD t 1 log ME t ME t 1 Equation (1) shows that RDME t can be expressed (logarithmically) as the sum of lagged R&D intensity plus a log change in R&D intensity. Equation (1) highlights that the positive association between RDME t and future returns is due to either a positive association with (1) lagged R&D intensity, (2) the current change in R&D intensity, or (3) a combination of both elements. Prior studies confirm this assertion as each element has significant power in explaining future return variation (see Chan et al. 2001; Chambers et al. 2002). However, Eq. (2) motivates our empirical design and offers an alternative interpretation of the positive association between current R&D intensity (RDME t ) and future returns. Equation (2) shows RDME t as the logarithmic sum of lagged R&D intensity and R&D growth, minus change in market value of equity. If we hold constant the effect on market value of equity due to equity issuances/repurchases, we can interpret the change in market value of equity element as a measure of the aggregation of all new value-relevant information incorporated into stock price by investors over a given period of time. This value-relevant information includes information related to R&D investment and information unrelated to R&D investment (for example, cash flows, accruals, capital expenditures, changes in risk, changes in earnings expectations). ð2þ

7 The effect of R&D on future returns and earnings forecasts Expressing RDME t as reflected in Eq. (2) demonstrates how the types of information captured by RDME t explain future returns. Prior studies have shown that firms with high RDME t values tend to have recently realized large negative returns and lower profitability (for example, Chan et al. 2001). Complementing this research, studies have shown that in subsequent periods, high R&D firms tend to realize higher profitability and higher future returns (for example, Eberhart et al. 2004). This stylized empirical fact leads to the interpretation that current R&D investment is mispriced by investors leading to higher future returns when this mispricing is corrected. However, other firm characteristics, unrelated to a firm-specific R&D investment, could also explain the future returns. For example, if investors price the expected future earnings or future asset growth differently for R&D firms than non-r&d firms, then it is possible that R&D firms will have a distinct future return pattern from that of non-r&d firms. This pattern, however, may be unrelated to the firm s R&D investment. Nonetheless, it will be captured in RDME t (and DRDME t-s,t ), which are the primary variables used to measure a firm s R&D activity. To examine this possibility, we leverage the logarithmic decomposition noted in Eq. (2) and decompose RDME t into two distinct components: an R&D component and a non-r&d component. Specifically, by regressing future returns against elements of (2), we can distill from the components of RDME t whether its relation with future returns is due to how investors view R&D investment, other firm characteristics captured by RDME t, or a combination of both. Before estimating these regressions, we need to transform the elements of (2) into log return variables that more closely resemble the information-based constructs that we describe above. We build from Daniel and Titman (2006), whose empirical design partitions realized returns into returns attributable to accounting performance measures, termed tangible returns, and returns attributable to non-accounting measures of performance, termed intangible returns. As noted above, we assume that a good measure of information about a firm is the total return for a dollar invested in the firm at the beginning of the period, or log market returns. For illustrative purposes, we show that the change in price over a given period can be transformed into the per share change in value over a given period (log return) as follows. Per the CRSP/Compustat data manual (see also Daniel and Titman 2006), the relation between log returns (market_return t-s,t ) and log price changes can be expressed as follows: market return t s;t Xt log P s f s þ D s ¼ ¼ s¼t sþ1 Xt s¼t sþ1 Xt s¼t sþ1 log log P s P s 1 P s P s 1 P s 1 þ logðf s Þ þ log 1 þ D s P s f s þ shradj fac; where f s is the price adjustment factor due to stock splits and rights issues between s-1 and s; D s is the value of all cash distributions paid between s-1 and s; P s is the ð3þ

8 D. C. Donelson, R. J. Resutek price per share at time s. Equation (3) shows that the log return over a given period of time is equal to the sum of log change in price, plus the log return earned from cash distributions to equity holders. From an economic intuition perspective, the importance of (3) is that it highlights that log returns are unaffected by changes in firm value due to equity issuances/repurchases and unaffected by stock splits and dividends. This is important because Daniel and Titman (2006) show that, while absolute growth measures are negatively associated with future returns, the negative relation is entirely due to growth associated with equity issuance/repurchase activity, not growth on a per-share basis. Following Eq. (3), we transform the per share change in R&D expenditures over a period into a log return metric. Specifically, we compute a R&D return measure that captures the growth in R&D per dollar of equity invested at time t - s, rd_return t-s,t, as follows: 5 rd return t s;t ¼ Xt RD=share s log þ shradj fac:c ð4þ RD=share s¼t sþ1 s 1 Similar to (3), Eq. (4) captures the per share change in R&D investment over a given period of time. However, distinct from prior studies examining R&D, rd_return t-s,t measures growth in R&D adjusting for growth due to equity issuance/ repurchase activity. By measuring R&D changes on a per share basis, we can make cleaner inferences on the effect of organic R&D growth that are unrelated to R&D growth due to equity issuance. This distinction is important given the strong negative relation between net share issuance activity and future returns. With growth in R&D now transformed into a log return scale, we substitute (3) and (4) into Eq. (2) and express log(rdme t ) as the following return-based identity: LogðRDME t Þ ¼ rdme t ¼ rdme t s þ rd return t s;t market return t s;t : ð5þ Given that market_return t-s,t (the log market return between t-s and t) incorporates all value-relevant information investors incorporate into price between t-s and t, it is important to separately distill the value-relevant information relating to R&D from that unrelated to R&D. We accomplish this by regressing market_return t-s,t on the two other components of rdme t (rdme t-s and rd_return t-s,t ). Specifically, to compute the value change from non-r&d information between t-s and t, we annually regress the realized log market returns inclusive of dividends (market_return i,(t-s,t) ), on lagged R&D intensity (rdme i,t-s ) and the measure of R&D returns described above (rd_return i,(t-s,t) ): market return i;ðt s;tþ ¼ c 0 þ c 1 rdme i;ðt sþ þ c 2 rd return i;ðt s;tþ þ u i;t : ð6þ From this regression, we derive two distinct components. The fitted value from the regression represents the portion of realized returns (or total value-relevant information) attributable to R&D investment (both level and change). The residual 5 Note that the second element of rd_return t-s,t, shradj_fac is equal to the (log) number of shares one would have at time t, per shares held at time t-s, if one reinvested all cash distributions back into the stock. In other words, shradj_fac captures the effect of reinvesting cash dividends (and other cash distributions) back into shares of common stock.

9 The effect of R&D on future returns and earnings forecasts represents the component of realized returns that is unrelated (orthogonal) to R&D. These residuals are defined as non-r&d returns (nrd_return t-s,t ). 6 By construction, total log market return is equal to the sum of the log R&D returns plus the log non-r&d returns (market_return t-s,t = rd_return t-s,t? nrd_return t-s,t ). This empirical design provides several advantages. First, by partitioning total value-relevant information (as proxied by market_return t-s,t ) into two orthogonal components representing the effects of R&D investment and non-r&d information on price, we avoid concerns that significant (or insignificant) associations between future returns and our explanatory variables are the result of omitted correlated variables. Second, the advantage of using rd_return t-s,t as a measure of R&D growth as opposed to using a measure of total growth in R&D (for example, Dlog(R&D) t-s,t ) is that rd_return t-s,t captures growth in R&D spending per dollar of equity invested at time t-s. For example, consider a R&D firm that initiates a seasoned equity offering between t - 1 and t and doubles the number of common shares outstanding. With the equity infusion it receives, it subsequently doubles its R&D spending. Total growth in R&D between t - 1 and t would be 100%. However, growth in R&D for an investor invested at t - 1, measured by rd_return t-1,t would be zero, as the log change in R&D per share would be zero (in other words, the growth in R&D was due to new investment from new equity, not existing equity). Thus, our research design minimizes concern that any relation between future returns and change in R&D is driven by equity issuance activity. 7 Third, although our empirical design uses components from a scaled variable (RDME t ), the components derived from the decomposition and used as explanatory variables are returns-based. This transformation reduces the distortive effect on inferences due to biases related to the manner in which accounting variables are scaled. Scale-related biases can lead to attenuated standard errors due to heteroskedasticity and coefficient bias (Barth and Kallapur 1996). While Barth and Kallapur (1996) suggest including a scale variable in the regression as an additional control, this solution is problematic in the R&D setting where a vast literature exists relating R&D investment efficiency to firm scale (for example, Cohen and Klepper 1996). 8 Ultimately, it is unlikely that any proxy could control perfectly for scale differences across firms independent of the level of R&D investment. 6 The use of the term intangible by Daniel and Titman (2006) and Resutek (2010) refers to nonaccounting information. Because this concept is related to the intangible nature of R&D assets, we generally avoid the term intangible returns and instead utilize non-r&d Returns to avoid ambiguity or confusion when we examine returns correlated with reported R&D. 7 The same intuition holds, in reverse, for firms who repurchase outstanding shares. 8 In addition, standard accounting scale measures such as earnings and book value are biased for R&D firms (for example, Lev et al. 2005). This is particularly problematic given that the extent of bias is related to the efficiency of investment because more efficient R&D investment will create a higher level of unrecognized assets. In turn, R&D investment efficiency is related to firm scale (see, for example, Cohen and Klepper 1996).

10 D. C. Donelson, R. J. Resutek 4 Empirical analysis 4.1 Sample selection and data description Our primary sample period includes firms with fiscal year-ends between January 1973 and December To be included in the sample, firms must appear in the Compustat database and have positive R&D expenditures in years t and t - 1. This yields a primary sample of roughly 1,600 firms per year (see Panel A of Table 1 for detailed sample construction). Future return computations span between July of year t? 1 and June of year t? 2 for all firms with fiscal year-ends between April December of year t, January March of year t? 1. Monthly returns are from CRSP. All other variables are computed from Compustat. All accounting variables (for example, R&D scaled by market equity, RDME t ) are annually winsorized at the 1st and 99th percentiles. 4.2 Descriptive statistics Panels B and C of Table 1 report descriptive statistics of our primary sample. Consistent with cross-sectional properties of the Fama and MacBeth (1973) regressions and portfolio analysis reported in later tables, panels B and C report time-series means of the annual descriptive statistics. Panel B of Table 1 presents summary statistics for the full sample. The results are largely consistent with prior studies, but certain firm characteristics are worth noting. First, R&D firms have smaller market capitalizations. Further, consistent with the conjecture of Daniel and Titman (2006) that R&D investment could be related to their measure of intangible returns, panel B shows that most of the firms in this sample can be classified as growth firms (book-to-market \1.0). Given the strong negative relation between future returns and growth firms (Lakonishok et al. 1994; Fama and French 1995), this suggests that the positive relation between R&D firms and future returns is not a direct transformation of the value/growth anomaly. Finally, while the average firm in our sample is increasing its R&D investment level (both on a total and per share basis), there is a considerable number of firms reducing their R&D investment levels. Panel C reports a correlation matrix for key variables and provides suggestive evidence that other information captured by R&D intensity measures or correlated with R&D growth may be responsible for the future return patterns attributed to R&D firms. First, there is a strong negative association (q =-0.33) between current R&D intensity (rdme t ) and the most recent 1-year realized stock return, implying that firms classified as high (low) R&D intensity firms tend to have just realized low (high) market returns, consistent with Chan et al. (2001). Second, there is a stronger negative relation between rdme t and nrd_return t-1,t (-0.42) than the positive relation between rdme t and rd_return t-1,t (0.09). These relations suggest that information incorporated into stock price over the past year that is unrelated to R&D has a much more significant effect on rdme t than the effect of R&D. Finally, the most recent 1-year realized stock return is positively associated with the R&D

12 D. C. Donelson, R. J. Resutek growth over the same period. This implies that R&D is viewed positively by investors and not negatively as prior studies suggest. In summary, these correlations provide suggestive evidence that the positive relation between rdme t and future returns may be due to information captured in rdme t that is unrelated to R&D investment. Subsequent analysis uses regression analysis and portfolio sorts to examine the relation between R&D investment and future returns in a multivariate setting that controls for firm characteristics that are jointly correlated with R&D and future returns. 4.3 Regression analysis Panel C of Table 1 reflects a high correlation between current and lagged R&D intensity measures (for rdme t with rdme t-1, q = 0.82), suggesting that R&D intensity is very persistent. Also, the correlations suggest that R&D intensity may explain more future return variation than changes in R&D investment. However, as discussed above, measures of R&D intensity are jointly affected by R&D investment and other firm characteristics. Accordingly, we turn to regression analysis to distill the future return variation explained by R&D. We use the log-linear return components derived from rdme t as our proxies for the information investors incorporate into price related to (1) the level of R&D investment (rdme t-s ), (2) the per share change in R&D investment (rd_return t-s,t ), and (3) all other information that is unrelated to R&D but incorporated into price (nrd_return t-s,t ) (see Sect. 3 for detailed discussion of the construction and interpretation of these variables). We employ Fama and MacBeth (1973) regressions of future monthly returns on the log-linear return components of rdme t. The null hypothesis is that consistent with efficient markets, risk-neutral investors, and rational expectations, realized return variation explained by level of R&D investment and change in R&D investment should be unrelated to future returns. However, if future return variation is explained by the lagged level or current change in R&D investment, both publicly available accounting variables, the null hypothesis can be rejected. Panel A of Table 2 reports the average slope coefficients and time-series mean t statistics from annual regressions of log market return (market_return t-s,t ) on the log-linear return components of rdme t. If R&D information is value-relevant, we expect significant coefficients on the R&D components of rdme t (rdme t-s, rd_return t-s,t ). Consistent with this intuition, panel A shows that both measures of lagged R&D intensity and both measures of per share growth in R&D (rd_return t-s,t ) are positively associated with the log market return over the respective periods. Interestingly, the per share growth in R&D is positively associated with contemporaneous returns. Prior studies suggest that investors view current R&D expenditures negatively and bid stock price down. The positive slopes on rdme t-s and rd_return t-s,t suggest that investors view R&D positively. We investigate this result more formally in Table 6. Panels B and C of Table 2 reports the results from our regression analysis for all firms (panel B) and firms with share price greater than or equal to $5/share as of

14 D. C. Donelson, R. J. Resutek June 30, t? 1 (panel C). Regression 1 in each panel establishes the economically significant relation between future monthly returns and R&D intensity as measured by rdme t. Regression 2 examines the relation of future monthly returns with rdme t-1 and rd_return t-1,t. Interestingly, regression 2 suggests that per share growth in R&D (rd_return t-1,t ) is not associated with future returns once beginning of period R&D intensity is controlled, suggestive that the level of R&D investment is more strongly associated with future returns than the change in R&D investment. Regression 3 completes the 1-year log-linear return decomposition of rdme t. Regression 3 suggests that rdme t forecasts future returns due to information captured in lagged R&D intensity (rdme t-1 ) and lagged 1-year market return (market_return t-1,t ), while per share change in R&D does not explain future return variation. Note that because market_return t-1,t contains all value-relevant information investors incorporate into price between t - 1 and t, including R&D investment information (rd_return t-1,t ), multicollinearity could attenuate the significance of coefficients on the R&D components. Regression 4 solves this problem by substituting for market_return t-1,t the variable nrd_return t-1,t. As detailed above, nrd_return t-1,t represents the component of market_return t-1,t that is orthogonal to the level and change in R&D investment. Thus, from an econometric perspective, we can measure the incremental relation between future returns and all other non- R&D value-relevant information investors incorporate into stock price without concern of possible multicollinearity across control variables affecting inferences. Regression 4 suggests that the significant relation between future returns and rdme t is due to a combination of a positive relation between lagged R&D intensity with future returns and a negative relation between nrd_return t-1,t with future returns. 9 The positive and significant relation between rdme t-1 and future returns suggests three possible explanations for future returns: R&D investments made prior to t - 1, other non-r&d information incorporated into price prior to t - 1 and captured in rdme t-1, or a combination of the two. To determine what explains the significant relation between future returns and rdme t-1, we examine regression 5, which is identical to regression 4 except that we substitute nrd_return t-5,t for nrd_return t-1,t. If the positive relation between rdme t-1 and future returns noted in regression 4 is due to information investors incorporate into price that is unrelated to R&D investment between t - 5 and t - 1, then rdme t-1 should be unrelated to future returns once nrd_return t-5,t is controlled. However, if the positive association between future returns and rdme t-1 is due to R&D investments made between t - 5 and t - 1, then rdme t-1 should still be positively associated with future returns after controlling for nrd_return t-5,t. Consistent with the former idea, regression 5 shows that nrd_return t-5,t subsumes the explanatory power of rdme t-1. Specifically, regression 5 notes an insignificant relation between future returns and both R&D components (rdme t-1, rd_return t-1,t ) while a strong negative relation is noted with nrd_return t-5,t. Inferences from regression 5 suggest that the significant relation between rdme t-1 and future returns 9 Even though nrd_return t-1,t is orthogonal to rdme t-1 and rd_return t-1,t, the coefficients on these variables are slightly different between (2) and (4) because we do not require that a full set of 12 future monthly returns to exist to be included in our sample. Accordingly, since some of the firms used to compute nrd_return t-1,t do not have a complete set of 12 future returns, the coefficients change slightly.

15 The effect of R&D on future returns and earnings forecasts noted in regression 4 is due to value-relevant information investors incorporate into stock price between t - 5 and t that is unrelated to R&D investment information. Finally, regression 6 shows that nrd_return t-5,t is strongly associated with future returns in both panel B and panel C. The weaker relation between future returns and nrd_return t-5,t noted in regression 5 is due to the fact that rdme t-1 and nrd_return t-5,t are highly correlated. The results in Table 2 suggest that there is no significant relation between future return variation and a firm s R&D activity. Rather, the positive relation between R&D activity and future returns documented in prior studies is due to firm characteristics unrelated to the firm s R&D activity but present in R&D firms. These characteristics are captured in our proxy for non-r&d information, nrd_return t-s,t. While this explanation may at first appear circular, the intuition is very simple. A combination of firm characteristics, risk factor exposures, or mispricing captured by nrd_return t-s,t is responsible for the seemingly positive relation between R&D activity and future returns. Since nrd_return t-s,t is unrelated to R&D activity by construction and increases or decreases in R&D activity are unrelated to future return variation, this implies that changes in R&D investment do not affect firm risk and changes in R&D are not mispriced by investors. Rather, the coefficients reported in Table 2 imply that other non-r&d firm characteristics that are present in R&D firms are mispriced or are associated with firm risk. It is these other characteristics captured by nrd_return t-s,t, not R&D, that explain future returns. Admittedly, explaining the R&D anomaly as a derivative of another anomaly using a variable that is defined by what it is not is somewhat unsatisfying. We examine these issues further in later analysis (Table 6) and attempt to place some structure to the composition of the nrd_return t-s,t variable. 4.4 Portfolio tests Table 3 reports the results of non-parametric portfolio sorts. The purpose of these non-parametric tests is to address possible concerns that a non-linear relation between changes in R&D and future returns leads to the insignificant association we document. Panels A and C report the results of annual sorts of firms into quintiles based the level of R&D intensity (RDME t ) and on the 1-year change in R&D intensity (DRDME t-1,t ) respectively. These panels serve to establish the statistical and economic significance of the future return variation explained by these variables and to provide benchmark hedge returns to compare with prior studies. Consistent with the tenor of prior studies, panel A reports an economically and statistically significant hedge return earned by taking long (short) positions in firms with high (low) RDME t values. The average monthly hedge return is more than 1.1%, yielding an economically significant annual hedge return of more than 13%. Panel A shows that sorting firms into quintiles based on RDME t also sorts firms into quintiles based on growth in non-r&d (nrd_return t-5,t ) elements. Since nrd_return t-5,t explains significant future return variation, panel B controls for nrd_return t-5,t while maximizing the dispersion in the variable of interest, RDME t. Specifically, we annually sort firms into percentiles based on nrd_return t-5,t.we

16 D. C. Donelson, R. J. Resutek Table 3 Portfolio sorts of RDME t, DRDME t-5,t, and nrd_return t-s,t Q1 Q2 Q3 Q4 Q5 Ret diff. (%) FM t Panel A: Annual sorts on RDME t RDME t nrd_return t-5,t (0.294) (0.947) Avg. monthly return t,t?1 (all) 1.06% 1.33% 1.50% 1.71% 2.24% 1.18 (4.14) Panel B: Annual sorts on RDME t, controlling for nrd_return t-5,t RDME t nrd_return t-5,t (0.007) (0.018) (0.029) Avg. monthly return t,t?1 (all) 1.42% 1.50% 1.52% 1.68% 1.78% 0.36 (1.89) Panel C: Annual sorts on DRDME t-1,t DRDME t-1,t (0.077) nrd_return t-1,t Avg. monthly return t,t?1 (all) 1.60% 1.30% 1.31% 1.45% 2.16% 0.56 (3.12) Panel D: Annual sorts on DRDME t-1,t, controlling for nrd_return t-1,t DRDME t-1,t (0.048) (0.003) nrd_return t-1,t (0.179) (0.072) Avg. monthly return t,t?1 (all) 1.59% 1.54% 1.47% 1.60% 1.61% 0.03 (0.16) Above table reports the results of annual portfolio sorts based on the R&D characteristics of the sample firms. Panels A and C report the average of firm characteristics and monthly returns for quintiles formed from annual sorts based on RDME t and DRDME t-1,t respectively. All variables are defined the same as in prior tables. All characteristic averages represent Fama Macbeth averages (an average of annual averages). Hedge returns represent the hypothetical monthly return from taking a long (short) position in firms classified in Q5 (Q1) Panels B and D report the results of annual portfolio sorts based on RDME t and DRDME t-5,t controlling for nrd_return t-5,t and nrd_return t-1,t respectively. To maximize the variation in the variable of interest, while minimizing the variation in nrd_return t-s,t, we perform a series of dependent sorts. At the end of June in each year, we sort all firms into annual percentiles ranked on nrd_return t-s,t. Each of these annual nrd_return t-s,t deciles is then sorted into annual quintiles based on RDME t (Panel B) and DRDME t-1,t (Panel D). We then pool the quintiles across years, thereby maximizing dispersion in RDME t and DRDME t-1,t (Panels B and D respectively), while minimizing the dispersion in nrd_return t-s,t then sort these annual percentiles into quintiles based on RDME t. Annual quintiles are then aggregated, thereby maximizing dispersion in RDME t while minimizing dispersion in nrd_return t-5,t. Panel B reports the results of this analysis. Interestingly, there is a marginally significant relation between RDME t and future returns after controlling for nrd_return t-5,t in the full sample. This said, differences in the economic and statistical significance in the hedge returns reported across panels A and B essentially confirm that the R&D investments made by firms are unrelated to future returns. Panel C sorts firms into annual quintiles based on the 1-year change in R&D intensity, proxied for by DRDME t-1,t. Consistent with the tenor of Chambers et al. (2002), monthly hedge returns realized from taking hypothetical long (short) positions in high (low) DRDME t-1,t firms is an economically significant 0.56% per month. However, sorts on DRDME t-1,t jointly produces variation in not just DRDME t-1,t but also nrd_return t-1,t. Accordingly, using the same empirical portfolio design of panel B, in panel D we control for nrd_return t-1,t while

17 The effect of R&D on future returns and earnings forecasts maximizing dispersion in DRDME t-1,t. Consistent with the tenor of prior tables, panel D shows that the power of DRDME t-1,t to forecast future returns is unrelated to R&D investment of the firms. Rather, the relation between future returns and DRDME t-1,t is due to firm characteristics shared by R&D firms (and measured by nrd_return t-1,t ) that are unrelated to R&D activity Earnings, R&D, and intangible returns In Sect. 4, we examined the relation between the R&D and non-r&d components of realized returns and future returns. Our empirical evidence suggests that while R&D firms may earn higher future returns than non-r&d firms, this pattern is unrelated to both the level and the change in R&D investment. Instead, our empirical evidence suggests that the positive future returns associated with R&D by prior studies are actually due to the non-r&d information investors incorporate into price (labeled nrd_return t-s,t in the prior section). In this section, we examine the effect that R&D and non-r&d return components have on the future earnings expectations of investors and analysts. We are interested in understanding these relations for two reasons. First, prior studies (for example, Lev et al. 2005) have coupled a strong positive relation between current period R&D investment and future profitability with the strong positive association between current period R&D and future returns as evidence that investors misprice the current earnings of R&D firms, leading to positive future returns. An alternative explanation for the relation noted in prior studies is that nrd_return t-s,t, the information that investors incorporate into price that is unrelated to R&D, is also positively associated with future earnings. Accordingly, it could be the information contained in nrd_return t-s,t and captured by R&D intensity measures, not R&D, that biases future earnings estimates. We examine this in Sect Second, an alternative interpretation of our results and those of prior R&D studies is that R&D distorts earnings and therefore mechanically weakens the relation between accounting-based performance measures such as earnings and future returns. That is, if R&D distorts earnings, it essentially adds noise to earnings as a performance measure. From an econometric perspective, a noisy explanatory variable will mechanically cause the error term in any regression to explain a larger percentage of the dependent variable. For purposes of our empirical design, this would mean that log book return would explain a smaller percentage of total log market return (market_return t-s,t ) for R&D firms relative to non-r&d firms. If investors systematically underweight the log book return of R&D firms relative to non-r&d firms, this might explain why prior studies such as Penman and Zhang (2002) find that controlling for the conservative nature of accounting for R&D helps 10 For brevity, we do not report portfolio results for firms trading at more than $5/share (with portfolio breakpoints determined using only firms with share prices greater than $5). Results are qualitatively identical to those reported in Table 3.

18 D. C. Donelson, R. J. Resutek explain future earnings of R&D firms even after controlling for current earnings. We examine this possibility more closely in Sect The relation between R&D activity and analyst forecast errors Table 4 directly examines the relation between analyst forecast errors in t? 1 and the log-linear return components of rdme t. The purpose of the regressions in Table 4 is to determine whether errors in analyst earnings expectations that prior studies have attributed to R&D are actually due to the value-relevant information captured by nrd_return t-s,t. For example, if analysts underestimate the positive implications of current R&D investment on future profitability, as suggested in prior studies, we should see a significant positive relation between our R&D variables (rdme t-s, rd_return t-s,t ) and analyst forecast errors. If, however, analyst forecasts are affected by nrd_return t-s,t and not by R&D investment, as our prior tables suggest, we should see a significant negative relation between analyst forecast errors and nrd_return t-s,t and insignificant relations with our R&D variables. 11 Thus, Table 4 serves as a direct test of earnings fixation as an explanation for the positive association of current period R&D and future returns. We measure analyst forecast errors as follows. We compute the consensus analyst forecast error as the mean analyst forecast for year t? 1 as of the sixth month of year t? 1. For example, for a firm with a calendar fiscal year, we compute the consensus forecast for year t? 1 at the end of June, t? 1. Analyst forecast errors are computed as actual earnings per share (as reported by I/B/E/S) minus the consensus earnings forecast as of the sixth month. Forecast variables are scaled by price as of the beginning of the fiscal year. To minimize the distortive effects of extreme observations, we trim all observations with unexpected earnings greater than/less than 5% of market value of equity. Regressions 1 through 3 examine the relation between rdme t, its 1-year log-linear return components, and analyst forecast errors. Results are largely in line with the tenor of earlier results. Lagged R&D intensity (rdme t-1 ) is strongly associated with forecast errors, while per share change in R&D (rd_return t-1,t ) is unrelated to forecast errors. Interestingly, nrd_return t-1,t is unrelated to analyst forecast errors and the coefficient is positive. Regressions 4 and 5 examine the relation between analyst forecast errors and the 5-year log-linear return components of rdme t. Similar to Table 2, regressions 4 and 5 examine the relation between the components of a 5-year decomposition of rdme t and analyst forecast errors to see if the positive relation between analyst forecast errors and rdme t-1 is due to prior period R&D activity (rd_return t-5,t-1, and 11 Prior research finds mixed results regarding the relation between analyst forecast errors and R&D. Thomas (2002) finds a generally positive relation between R&D scaled by sales and forecast errors, but the relation becomes negative when return volatility is controlled. Kothari et al. (2002), however, note that controlling for volatility may take away the treatment effect of R&D. Chambers et al. (2002) find a negative relation between R&D scaled by assets and forecast errors. Barron et al. (2002) find greater dispersion in forecast errors for firms with high R&D investment, measured as R&D expense scaled by total expense.

19 The effect of R&D on future returns and earnings forecasts Table 4 Analyst forecast errors Reg. Int. rdme t rdme t-1 rdme t-5 rd_return t-5,t-1 rd_return t-1,t nrd_ return t-5,t-1 nrd_ return t-1,t Panel A: Regressions of analyst forecast errors on components of RDME t (all firms) (-2.56) (2.30) (-2.28) (3.46) (-2.28) (3.47) (-0.50) (-2.73) (0.92) (-0.98) (0.12) (-5.09) (-0.50) (-0.95) (-0.02) Panel B: Regressions of analyst forecast errors on components of RDME t (Price C $5) (-3.86) (0.94) (-2.96) (2.63) (-1.00) (-3.06) (2.61) (-0.93) (-3.54) (0.36) (-0.96) (-0.32) (-6.09) (-1.00) (-1.14) (-0.45) (-1.76) (-3.61) (-1.91) (-3.21) (1.55) (1.29) (1.22) (3.76) (2.13) (2.06) Above table reports the results of regressions of analyst forecast errors on components of the log-linear return decomposition of the R&D-to-market ratio at fiscal year-end t. Panel A reports results for all firms, while Panel B includes only firms with share prices C $5 as of June 30, t? 1. All variables except analyst forecast errors are as defined earlier. We compute the consensus analyst forecast error as the mean analyst forecast for year t? 1 as of the sixth month of year t? 1. Analyst forecast errors are computed as actual earnings per share (as reported by I/B/E/S) minus the consensus earnings forecast as of the sixth month. Forecast variables are scaled by price as of the beginning of fiscal year t. To minimize the distortive effects of extreme observations, we trim all observations with unexpected earnings greater than 5% of market value of equity. All coefficients are multiplied by 100. t statistics are reported in parentheses with standard errors clustered by firm and year rd_return t-1,t ) or from prior-period non-r&d activity (nrd_return t-5,t-1, and nrd_return t-1,t ). Primary inferences are consistent with the tenor of our prior tables. That is, even though R&D is positively associated with future profitability (as shown in prior studies), it does not bias future earnings forecasts in that the coefficients on both rdme t-5, rd_return t-1,t and rd_return t-5,t-1 are all insignificant. Rather, the biased earnings forecasts are actually due to the non-r&d activity of R&D firms captured by nrd_return t-s,t, in particular nrd_return t-5,t The insignificant relation between nrd_return t-1,t and analyst forecast errors is likely because nrd_return t-1,t jointly captures elements related to the opposing forces of short term return momentum and long term return reversal, which each have opposing relations with analyst forecast errors.

20 D. C. Donelson, R. J. Resutek 5.2 Differential investor interpretation of earnings information An alternative interpretation of the results we report in Tables 2 and 3 is that our non-accounting based return metric, nrd_return t-s,t, explains a significantly larger percentage of cross-sectional future return variation in firms with noisy earnings. In other words, if R&D decreases the interpretability of earnings, investors will weight it less than they should and nrd_return t-s,t will absorb the excess variation. To address this concern, we examine whether there is a difference in how R&D affects investors interpretation of earnings. If R&D affects the manner in which investors weight the information contained in earnings, then we should find differential slope coefficients across firm types with varying R&D levels. We decompose log book-to-market (bm t ) using the same research design as noted in Sect. 3 for rdme t. We interpret log book return (book_return t-1,t ) as a measure of earnings and intangible_return t-s,t as a measure of all value-relevant information between t-s and t not captured by log book return (or lagged book-to-market). 13 This interpretation is consistent with that used in Daniel and Titman (2006). Further, by examining whether significant differences exist between how investors interpret the earnings of firms with varying levels of R&D intensity relative to the earnings of non-r&d firms, inferences can be tied more directly to those in the value/growth literature stream. We are specifically interested in the relation between future returns and the interaction of R&D and book_return t-1,t. In Table 5, we regress future returns on the log return components of log book-to-market (bm t ) and an R&D rank variable. Specifically, each year we rank all firms into one of five categories. All firms with no R&D investment have an RD_RNK of 0. Firms with non-zero R&D investments are sorted into equal-sized quartiles based on their current R&D intensity level (rdme t ), with the maximum RD_RNK = 4. In this specification, the slope coefficient on book_return t-1,t represents the relation between future monthly returns and log book return for non-r&d firms (when RD_RNK = 0). Accordingly, the slope coefficient on RD_RNK 9 book_return t-1,t represents the incremental difference to the coefficient on book_return t-1,t for R&D firms across varying R&D intensity levels. If this interaction term is significant, this implies that investors interpretation of earnings is significantly affected by a firm s R&D investment, perhaps due to the noise embedded into earnings by R&D. If the interaction between RD_RNK and book_return t-1,t is insignificant, this implies that the earnings of R&D firms are no more or less informative than those of non- R&D firms. Similarly, a significant relation between future returns and the interaction of RD_RNK 9 intangible_return t-5,t would suggest that investors price non-earnings related information differently for R&D firms than non-r&d 13 Variation in Dlog(B) t-1,t is explained by earnings in period t once equity issuance and repurchase activity is controlled. Since book_return t-1,t equals Dlog(B) t-1,t adjusted for equity issuance, we interpret book_return t-1,t as representing earnings. We acknowledge that dirty surplus accounting could cause book_return t-1,t = earnings t in some observations but believe that this assumption is reasonable in expectation (in other words, in expectation, change in book value should equal earnings plus equity issuance/repurchase activity).

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3. LITERATURE REVIEW Fama (1998) argues that over-reaction of some events and under-reaction to others implies that investors are unbiased in their reaction to information, and thus behavioral models cannot